(Bloomberg) — Chicago’s public pension debt is $36 billion and growing, it’s facing $550 million in budget deficits over the next three years and this summer the state had to bail out a school system that was flirting with insolvency.

Yet next month, the nation’s third-largest city — whose bonds were downgraded to junk by Moody’s Investors Service two years ago — will start selling as much as $3 billion of debt that another rating company considers as safe as U.S. Treasuries.

That’s because Chicago is selling off its right to receive sales-tax revenue from Illinois to a separate public corporation, which will issue new bonds backed by those funds, a structure called securitization. Because bondholders will be insulated from the city’s finances and have a legal claim to the sales-tax money, Fitch Ratings deems the bonds AAA.

Some investors fear Chicago’s approach may kick off a wave of securitizations by fiscally stressed municipalities that would increase their risk by siphoning away cash that backs bonds secured only by a promise to repay. Last month, Connecticut, which had a $3.5 billion two-year deficit, approved a budget that authorizes new debt backed by state income tax so it could receive a higher rating than the state’s A+ general-obligation bonds.

“You are, through a process of alchemy, creating AAA rated debt,” said Christopher Dillon, a municipal bond portfolio specialist at T. Rowe Price Group Inc. “They’ve lowered their borrowing cost in the near term, but long term, it’s just a continued degradation of the full faith and credit at the general-obligation level.”

DETROIT CASTS A SHADOW

Since Detroit’s bankruptcy four years ago, investors in the $3.8 trillion municipal market have given greater scrutiny to securities backed by a government’s good word instead of a secure revenue stream. When that city emerged from court, holders of “limited” general-obligation bonds received 42 cents on the dollar for their investments, compared with 100 cents for owners of Detroit’s water and sewer debt.

Institutional Investors from Pacific Investment Management Co. to Standish Mellon Asset Management Co. have said they favor revenue bonds, which don’t compete for resources with public pensions, over general-obligation debt.

Creating separate entities to issue higher-rated debt isn’t a new phenomenon. New York City, Philadelphia, Washington, Nassau County and Buffalo, New York, have all issued higher-rated dedicated-tax bonds to save money. But Chicago’s sale comes as many cities face pressure from deeply underfunded pensions and opting for bankruptcy has lost some of its taint after a handful of governments did so after last decade’s recession, though Illinois municipalities aren’t allowed to take that step.

Chicago’s new bondholders will have a first claim to more than 90 percent of the approximately $715 million of sales-tax revenue collected each year, according to a presentation to Chicago’s aldermen. The state, which collects sales taxes, will send the revenue directly to the bond trustee. Any excess revenue will go to the city.

PUERTO RICO FIGHT

Some investors say the legal battle now being waged in federal court between Puerto Rico’s general-obligation debt owners and sales-tax bondholders shows that legal structures like the one set up in Chicago are no guaranty when a borrower goes bankrupt or encounters severe financial distress.

In 2006, Puerto Rico passed a law creating a separate entity to issue sales-tax backed bonds with a legal structure similar to Chicago. The commonwealth approved a 5.5 percent sales tax and sent a portion to an entity known as Cofina. The new tax-backed bonds issued by the agency had a bigger margin of safety to pay debt service and garnered A+ ratings, five levels higher than Puerto Rico’s general-obligation bonds at the time.

This year, Puerto Rico entered into a form of bankruptcy and Cofina bondholders discovered the debt might not be so secure.

In June, the island said it may need more than $400 million in sales-tax revenue held by Cofina’s bond trustee for government operations. Cofina bondholders are fighting the move in bankruptcy court. General-obligation bondholders assert the money belongs to them, arguing that the territory’s constitution guarantees them a first claim on the government’s resources.

“We’re seeing these structures don’t always stand up the way they were designed to in bankruptcy,” said Tamara Lowin, director of research at Belle Haven Investments. “The market’s not putting as much faith in them as they have in the past.”

Chicago will use the proceeds of the new bonds to pay off old, higher-coupon paper, thus cutting its overall interest costs for a little while. But since it runs a chronic deficit, it will soon be back in the market to borrow more, at which point it will have to pay up – since those AAA bonds are siphoning off so much money. Then the downward spiral will resume, with no more tricks available to delay the inevitable.

This was always the end game for the dozens of cities and states that have never – even during a historic bull market in financial assets – managed to balance their promises to public sector unions with their ability to generate tax revenue.

The question is what all these “failed states” will do to confidence in central governments’ ability to keep levitating the financial markets.